2023-07-31 08:05:00 ET
Summary
- There are some REITs every investor should own.
- They offer the best combination of yield, growth, value, and safety.
- We highlight two such REIT opportunities to not miss.
Typically, you can earn higher returns over time if you take higher risks, pick the right REITs, and diversify. Sometimes, risk factors will play out and you will suffer losses, but on average, you will do better over long time periods.
To give you an example: over time, I would expect Essential Properties Realty Trust ( EPRT ) to generate higher total returns than Realty Income ( O ). Both invest in net lease properties, but EPRT is a lot smaller and it focuses on a higher-yielding niche segment that's a bit riskier, but also a lot more rewarding.
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This is why we have two main portfolios, the Core Portfolio and the Retirement Portfolio.
The Core Portfolio aims to maximize total returns and so it will hold REITs like EPRT for the most part.
The Retirement Portfolio, on the other hand, aims to maximize safe income and so it will hold blue-chip REITs like O instead.
But sometimes, the market does weird things, and the blue chips get so heavily discounted that they could be included in both portfolios.
I think that this is what has happened with Alexandria Real Estate ( ARE ) and Crown Castle ( CCI ) .
Both are safer, blue-chip REITs, but they are today priced at such low valuations that they have become compelling even more for aggressive investors that typically wouldn't buy this type of REIT.
In what follows, we discuss both REITs and explain why we are investing heavily in them:
Alexandria Real Estate
This is a blue-chip REIT that we currently hold in our Retirement Portfolio because it has the potential to pay a lot of relatively safe dividend income over the coming decade. The yield is not particularly high, but it is safe and the company has been rapidly growing its dividend and we expect this growth to continue. This makes it a great pick for a conservative, income-driven investors.
But now, ARE is also becoming a great investment opportunity for investors who are attempting to maximize total returns.
Its share price has dropped a lot more than that of most other REITs and as a result, it is now priced at a steep discount and offers significant upside potential in a future recovery. Its share price is currently near the lowest point of the pandemic:
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Following this crash, ARE is now priced at an estimated 35-40% discount to its net asset value and 13.9x FFO, which is exceptionally low for a BBB+ rated blue-chip REIT with attractive growth prospects.
We suspect that the market is pricing ARE at such a low valuation because of three unjust reasons:
- Association with office REITs: A large portion of the market sees ARE as an office REIT. Historically, most investors have not clearly differentiated offices from life science buildings. Even NAREIT, the representative body of the REIT sector, continues to group ARE with office REITs to this day. It has led to a lot of confusion: is ARE an office REIT? Is it suffering from the same factors? Can offices be converted into life science buildings? By precaution, it appears that many investors have sold ARE and it caused its share price to crash along with other office REITs. But in reality, life science buildings enjoy very different fundamentals. Their rents are today growing rapidly because there is a limited supply of high-quality lab space, but there's a lot of demand for it, particularly in the post-covid world because the pandemic pushed a lot of capital into research & development. Moreover, the tenants of life science buildings will typically heavily invest in their labs and so it is very impractical for them to move all their equipment, making them more dependent on your property. It is also very costly or even impossible to convert most offices into life science buildings, which enjoy very unique characteristics and are only in demand in some very specific locations. Finally, unlike office buildings, life science properties are recession-resistant. So there is a disconnect here between the perception of the market and the reality of ARE's fundamentals and it is providing us an opportunity to accumulate shares at today's historically low valuation.
- Exposure to VC funding: Most of ARE's revenue is coming from big pharma companies that are publicly listed and/or investment-grade rated. This rental revenue is safe and predictable. But ARE also does business with lots of smaller biotech companies that rely more heavily on VC funding, which has been drying up lately. This is understandably concerning the market since many of these tenants are not profitable and rely on capital raises. But here's the thing: despite everything that happened last year, ARE's tenants just had their biggest and most successful VC funding year ever and it will take years for them to put this capital to work. I recently got to meet the management team at the Citi Global Property Conference and they felt confident that most of their tenants should be just fine and complained that the media headlines get it wrong.
- The surge in interest rates: Interest rates have risen a lot higher and it has an impact on all companies. But some companies should not be impacted as much as others. I would argue that ARE belongs to this group because of three reasons: (1) Alexandria has one of the strongest balance sheets in the REIT sector with a low 25% LTV (incl. preferred equity), 99% fixed rate debt, and a long 13.2-year average term with no maturities until 2025, and over $5 billion of liquidity available to pay off future maturities if needed. It also retains a lot of cash flow with its low 52% payout ratio. (2) Cap rates have not moved much in the life science sector because there is limited supply of high-quality life science buildings and so if you want to invest in this space, you just have to pay what the seller is asking for to get a piece of the growth. ARE is able to sell assets and/or raise equity via JVs at low cap rates to reinvest in higher-yielding development projects. (3) Finally, ARE's current leases are deeply below market, providing a bank of future growth that's highly predictable. Its rent growth has actually accelerated as leases have been rolling-over at 20%+ higher rates in recent years.
Alexandria Real Estate
For this reason, we think that ARE is now very attractive for both income and total return-oriented investors.
It offers a path to double-digit annual total returns from its 4% dividend yield and its 6-8% annual growth prospects, and then on top of that, we think that it offers 30-50% upside potential to fair value, but quite possibly more if and when interest rates return to lower levels.
Therefore, we recently included ARE also as part of our Core Portfolio. ARE has been one of the best-performing REITs of all time since going public, outperforming even the likes of Berkshire Hathaway ( BRK.B ) and Walmart ( WMT ) since going public about 25 years ago.
It rarely comes on sale so we don't want to miss this one:
Crown Castle
If Alexandria is the cheapest blue-chip in today's market...
Then Crown Castle is the highest-yielding blue-chip in today's market.
Following its recent dip, it is now priced at a 5.62% dividend yield, which is truly exceptional for a rapidly growing, blue-chip cell tower REIT.
In fact, this is the highest yield ever for the company. For most of its history as a dividend-paying company, it has been priced at near a ~3% dividend yield, but today, you can get nearly double that:
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The reason why it yields so much is that the company has kept on hiking its dividend even as its share price collapsed over the past year.
It crashed because the company will face slower-than-usual growth over the next 2 years. T-Mobile's ( TMUS ) recent acquisition of Sprint will lead to some lease cancellations and hurt its near-term growth prospects.
But here's why we think that this is a great opportunity.
This is just a TEMPORARY crisis. The market only cares about the short-term and so it was quick to reprice CCI at a much lower level, but in reality, companies should be priced based on decades of excepted cash flow and so two years of slower growth really isn't the end of the world.
The management has clearly guided that they expect to return to faster growth in 2026 and they reaffirmed this on their first quarter conference call:
As we discussed in the press release, we expect our near-term results to be impacted by a combination of the Sprint network rationalization and a higher interest rate environment, which will result in minimal dividend growth in 2024 and 2025, despite strong projected underlying growth throughout our business. Looking past these discrete items, we believe our strategy will allow us to deliver on our long-term target of growing dividends per share at 7% to 8% per year .
And they once more reaffirmed this on the call of the second quarter :
In a normal go forward period of time over a multi-year period we're going to see about 5% tower organic revenue growth. And it's likely to move a little above, a little below that in certain periods. But I think generally that's what our expectation would be and that's what's driving our longer term. If we think about value creation, when we talk about being able to get back to a point where we're growing the dividend 7% to 8%, once we're beyond the Sprint site rationalization process that we're in the middle of once we're past that point, returning to being able to grow the dividend at 7% to 8% over a long period of time, underlying that is our assumption around top line growth.
And this is not coming from just any REIT management team. It is coming from a REIT that has one of the best track records:
Earning a 5.6% dividend yield from a blue-chip REIT that's able to grow its dividend by 7-8% per year is truly exceptional.
The price to pay is that we have to suffer two years of slower growth.
I think that this is very attractive because the return to faster growth is a clear catalyst that could lead to significant upside potential as the company eventually reprices at closer to a 4% dividend yield.
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As a result, CCI has recently become the largest holding of our Retirement Portfolio. The combination of high yield, rapid long-term growth prospects, and safety makes it very attractive to us. If there was another REIT from the Retirement Portfolio that I would consider adding to our Core Portfolio, it would be CCI.
For further details see:
2 REITs All Investors Should Own